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May 1, 2014

Rob Arnott Reveals: What’s Really Smart About Smart Beta

Research Affiliates’ reception area provides a vital clue to the thinking behind fundamental indexing

A lot of ink has been spilled on smart beta, the purportedly improved version of the beta an investor gets from investing in passive index funds, which are typically weighted by market capitalization.

So in making the trek down to Rob Arnott’s Research Affiliates headquarters in Newport Beach, Calif., I am hoping that a personal interview might lend that extra measure of insight.

And right at the get-go, my first big break comes as my eyes fall on a display case in the reception area housing an original two-volume first edition of Adam Smith’s 1776 classic work The Wealth of Nations.

One of the 238-year-old volumes is open to the page in which Smith states "the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry.”

I ask Arnott about this, and the self-described libertarian displays an impressive fluency in Smith’s thought and its application to current policy issues.

He decries the narrow way the U.S. assesses its own annual revenue — through gross domestic product:

“GDP measures spending, not prosperity,” he says, lamenting an excess of governmental spending on top of borrowing, and like behavior on the part of ordinary people using the equity in their homes as ATMs.

“The smell of that new car is nice — until it’s repossessed,” he acerbically jokes.

The confusion of consumption for prosperity that Arnott sees prevailing today means that we are encouraging spending rather than investing.

“It’s not possible to get a BA in economics without reading Keynes,” he bemoans. “It’s entirely possible to get a Ph.D in economics without cracking open Adam Smith.”

Echoing Smith (how many people nowadays use words like “betterment”?), he passionately sums up the matter:

“This is all to say I have a deep skepticism of the policy elite to make better decisions than the collective wisdom of the millions acting in their self-interest to seek their own betterment.”

As our interview went on, it became increasingly apparent that that same deep skepticism of elites may be precisely the basis of smart beta. By seeking a path apart from the dominant cap-weighted approach, Arnott is essentially expressing skepticism of market elites.

That became clear in his response to the criticism that smart beta is really a form of active investing.

While to some Boglehead types, any hint of active investing is seen as a source of shame, Research Affiliates does not eschew the term — the firm’s website proudly proclaims that its approach combines the best of both worlds.

But in our talk, while acknowledging that he has strong views at any time on what would make better and worse investment choices, he completely reframed who is guilty, as it were, of making active market bets — fingering elite investors and even dumb-beta passive index funds that go along for the ride.

“Relative to the economy, it is the market that is making the active bets. The market makes constant big active bets in the direction of growth, popularity and comfort, none of which should carry incremental rewards. It’s called a ‘risk premium,’ but none of those feel risky,” he says.

He adds, with conviction, that “from the perspective of the macroeconomy, fundamental indexing is the real passive strategy.”

So, ironically, it’s the active, market-aware “contra-trading” that gives Research Affiliates' beta strategy its smarts and which, according to this view, makes ordinary index funds dumb.

“Do you want to invest in cap-weighted, where the investment is tilted toward the most popular, most beloved, most expensive stocks or do you want to invest in the broad economy, including expensive and cheap stocks in proportion to their economic footprint — and add value by contra-trading the market’s most extravagant bets?” Arnott asks.

Defending his brand of fundamental indexes, Arnott adds:

“If the market is bidding up a company aggressively and the fundamentals are not keeping up with the price, we are grateful for the opportunity to sell. If the market hates a company, fundamental indexing will say: Its value is not showing up in prices yet; we’re going to top up.”

Amid the tangle with efficient markets proponents’ preference for dumb beta (a term Arnott did not use), the Research Affiliates founder parries a potential attack thusly:

“The beauty of smart beta is that if the Eugene Famas are correct and markets are pretty much efficient, then well-diversified bets away from the market won’t hurt us much.”

Indeed, diversification is of the essence of smart beta, according to Arnott, who acknowledges he did not coin the term:

“My definition of smart beta is broad diversification in the portfolio where the means of portfolio construction severs the relationship between price and weighting in the portfolio.”

His fundamental weighting accomplishes this. So do other alternative indexing strategies, such as equal portfolio weighting, he says. But any form of cap weighting, which includes Vanguard-style index funds and Dimensional Fund Advisors' value-tilted portfolios, do not qualify, Arnott says, and neither do price-weighting schemes such as the Dow Jones Industrial Average.

When his initial research in 2004-'05 showed that smart beta could deliver a 2% or more premium over cap-weighted index funds, critics questioned the validity of hypothetical backtested studies, suggesting Arnott’s indexes were a mere repackaging of value investing.

But Arnott says the idea was so simple, powerful and globally applicable that the backtesting in this case likely did not pick up too much “noise.”

What’s more, if it really was just a form of value investing, why has the strategy been such a success — delivering that 2%-plus return premium — during a period (since 2005) when value has underperformed? The Research Affiliates chief says he can’t wait to see the return premium when value has its day (since he acknowledges fundamental indexing is indeed tilted to value).

Noting that fully four decades of successful passive investing has only won a 17% market share, the quarter of 1% of the market ($125 billion) invested in smart beta over the past eight years has little to fear from imitators at this point.

In the final analysis, the incremental return advantage Arnott says his investors are getting by weighting portfolios according to business fundamentals such as total sales and book value seems to be quite consistent with Adam Smith’s thinking.

The other volume of Smith’s classic on display in Research Affiliates’ reception area was open to what is one of the Scottish economist’s best known quotes:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.”

Arnott wants to align his portfolios with the same invisible hand that brings prosperity out of the self-interested behavior of firms seeking to please customers and generate revenue.

Market participants, perhaps, lose track of that guiding hand by following the crowd rather than following the fundamentals.

Meanwhile, some market participants quite admire what Research Affiliates is doing, leading the potential problem of knock-offs.

But Arnott, who is careful to patent his firm’s ideas, considers such imitation “a gesture of respect” that prompts his own self-interested benevolence.

“It keeps us on our toes," he says. "We have to keep our products on the cutting edge. They have to be the best, and our service to clients has to be the best.”